“We hereby signal to short sell VXX shares (iPath S&P 500 VIX Short Term ETF) and buy a June 2012 VXX $20 call option for a net credit of $14.83, allocating 15% of our capital to this trade.”

What does this trade involve and how does it work?

There are two legs to this trade. Firstly, we short sold VXX.

To explain VXX, first we must talk about the about the VIX (Note the “I” - a small yet significant distinction).

VIX is an index that tracks S&P 500 volatility. The more volatile the U.S. equities market, the higher VIX is. Levels of VIX futures as of Friday 17th August 2012 are shown below:

As one will immediately notice, longer dated contracts are trading at a premium to shorter dated contracts. The VIX curve is therefore referred to as being in contango, since the longer dated futures contracts trade at a higher price than shorted dated futures.

The concept of roll refers to how one’s futures position can roll down the curve. Let us suppose that we decided we wanted to gain exposure to volatility by purchasing a VIX futures contract. Suppose we bought 17 November 2012 VIX futures at 18.23. This contract is roughly three months from expiration at present.

Now let us suppose that two months pass and the VIX is unchanged, as is the shape of the VIX futures curve. We still own the June VIX futures. However, since two months has passed they are now trading as one month VIX futures, not three months. Therefore we would expect them to be trading around 14.28, the same level where one month VIX futures were when we placed the trade. Therefore we have lost 3.95, without the VIX necessarily declining from the levels at which we took our position in futures. This loss has resulted from our futures position rolling down the VIX futures curve.

It is very important to reiterate this loss of 3.95 occurs without any change in volatility or the VIX curve. The loss is purely attributable to “roll down”.

If one sold rather than bought the VIX futures contract, the roll down loss would be a roll down profit.

Now that we’ve briefly talked about VIX, we can extend our explanation to VXX.

VXX is an ETF that aims to provide investors with long exposure to the short end of the VIX futures curve. Therefore they are continually buying and selling futures in order to maintain their target level of exposure. When the VIX futures curve is shaped how it is now, VXX will be declining in value each day, even if the VIX does not decline, due to the roll down effect described above.

The effects of roll down can be dramatic:

The above chart shows how the VIX (orange) has risen and fallen over the past 3 years. VXX has followed these movements short term, but due to roll down has decreased by a factor of 20+ since August 2009. Over the same period VIX has only halved in value. The 20x greater reduction in VXX is purely attributable to roll down.

Prior to placing this VXX trade, we sent out an explanatory article on VIX/roll down, just as we’re doing here. In the article we shared the following:

“We think the current economic environment will remain favourable to equities and therefore we do not anticipate a spike in the VIX in the short term. We therefore wish to capitalize on this view by short selling VXX and benefiting from the roll down.

And benefit we did. Here’s how VXX behaved during the time we short sold it:

Roll down worked nicely in our favour and we banked a 19.16% annualized return.

This is trade wasn’t an overwhelming success like some of our others. Our service has earned an average annualized return of 76.75% so far - much greater than the 19.16% annualized profit of this trade.

VIX spiked in June and meant we had to hold onto the trade for longer to realize a profit. Generally, had this been one of our more typical trades on gold for example, we would’ve likely had to close the position out early with a loss on our hands. Roll down ensured that even with the near doubling of VIX from March to June, our losses at the time were minimal. So although our return isn’t historically significant, neither was the risk we took on.

When informing subscribers about our intentions to place this trade we commented on the risks involved:

“The downside risks to this trade should not be understated. A spike in volatility, usually accompanied by a fall in the S&P 500 would cause this trade to incur losses. Whilst we think that a spike in volatility is unlikely in the near future, we are aware that there are events that are impossible to predict (such as the Japanese Tsunami) and these events can have devastating effect on short volatility positions. It is for this reason that selling volatility is often likened to picking up pennies on a railway, one can get run over by a train.

Therefore we wish to strictly limit our risk in this trade. Merely placing a stop loss is not good enough since if some event happened outside of US trading hours then it is possible that VXX could open higher than our stop, and therefore we would incur losses beyond our tolerance level.”

And how to mitigate them, with the second leg of the trade:

“We therefore would look to buy a call option on VXX as protection against the trade going drastically wrong. If one short sold VXX now at $17.30, but also bought a $25 call, then ones risk is strictly limited to $7.70+Call Premium. The call effectively acts as a guaranteed stop loss. Given the low cost of VXX calls (June $25 calls last traded at $1.05) we think this is a prudent way to manage our risk on the trade.”

We avoided any significant spikes in volatility whilst the position was open, so exercising the call option was unnecessary.

On the 13th of August we signalled to subscribers to close the trade citing 3 reasons:

1) “With the VIX approaching a 5 year low, we will look to close our short VXX trade this week. The equities market has been very stable since mid-May and we believe volatility is likely to rise in the coming months. Uncertainty around Europe could contribute to volatile trading in the US and would send the VIX higher, destroying our profits.”

2) “With the VIX futures curve flattening, the roll down effect is diminishing. Profits from here on out if we were to hold the trade would come at a slower rate and over that time we’d be susceptible to spikes in volatility in a potentially very unstable 4th and 1st quarter.”

3) “Our September $20 call is not far from expiry. Once this option expires, so too does our insurance policy.”

We rate this trade a success and will look to re-place it with the VIX at higher levels. The risk return dynamics remain very attractive. To see the other trades we currently have open and to receive our future trade recommendations, subscribe now and join a winning team.